Master Limited Partnerships for Income (Barrons)

SATURDAY, JUNE 2, 2012 Pipelines to Profits
By ANDREW BARY

The allure of master limited partnerships gets stronger, based on robust operating profits, tax breaks and a booming U.S. energy sector.


Master limited partnerships have been one of the best investments in the past 10 years, generating an annualized total return close to 16%, versus just 4% to 5% for the Dow industrials and the Standard & Poor's 500.

While these historical returns are excellent, the $250 billion sector has come under pressure, with the benchmark Alerian MLP Index down 9% this year. The yield stands at 6.6%.

MLPs mainly transport and store oil, natural gas, natural-gas liquids, gasoline, and other refined petroleum products. An estimated 65% of the industry's revenue comes from fees, many based on government-regulated rates. MLPs therefore offer some of the stability of electric utilities, plus growth potential tied to the construction of pipelines, plus storage and other facilities, driven by booming U.S. energy output.

MLPs are as attractive as they have been in some time," says Charles Lieberman, chief investment officer of Advisors Capital Management in Hasbrouck Heights, N.J. "Their investment opportunities are unparalleled as they expand their pipeline systems to provide access to new energy fields."

Comments Credit Suisse analyst John Edwards: "We conservatively see mid-single-digit annual growth in distributions over the next several years. Combine that with a mid-6% yield, and that looks pretty attractive, given current market conditions." Edwards says the yield gap between MLPs and the 10-year Treasury note is historically high at five percentage points, versus an average of 3.3 since 1999. That gap is skewed by the ultra-low yield of 1.5% on the Treasury, but MLPs stack up well against other yield-oriented groups, such as real-estate investment trusts and electric utilities, which yield in the 3% to 5% range.

MLPs historically have done very well when the yield gap has been around five percentage points. Edwards sees a total return exceeding 15% for MLPs over the next year.

Probably the biggest negative for MLPs is that they pay out nearly all of their cash flow in distributions, making them rely on the sometimes fickle capital markets to fund projects. This also makes the distributions vulnerable to setbacks. A drop this year in prices for oil and natural-gas liquids has hurt the sector.


Edwards favors large, well-capitalized MLPs like Enterprise Products Partners, Kinder Morgan Energy Partners, and Plains All American Pipeline, with yields in the 5% to 6% area. Lieberman is partial to higher yielders like Regency Energy Partners and Energy Transfer Partners that yield around 8%. Among high-yielding MLPs, Edwards likes Boardwalk Pipeline Partners, now at 8.2%.

MLP dividends technically are distributions, and more than 80% of the industry's payouts are tax-deferred. The taxed portion is treated as ordinary income, because master limited partnerships aren't subject to corporate taxes. The dividend's tax-deferred portion cuts investors' cost basis in MLP units (aka shares) and is subject to taxes when the units are sold, says New York tax expert Robert Willens. Many investors avoid these taxes if they hold the units until death and their estates are below the current $5 million inheritance-tax threshold.

Another minus is that investors get annual K-1 tax forms, rather than 1099s. This can result in more cumbersome and costly tax filings. The tax issue has helped spur the growth of exchange-traded funds and notes that do away with dreaded K-1s. Alerian MLP (AMLP) is the largest ETF and trades around 16, producing a yield of 6%. The drawback here is that appreciation in MLP holdings is subject to corporate taxes, dampening the upside.

The JPMorgan Alerian MLP, the largest exchange-traded note, is around $36 with a 6% yield. It offers a return linked to an Alerian index of 50 MLPs. A plus is no corporate taxation. A negative is that the shares amount to a debt obligation of JPMorgan Chase, exposing investors to credit risk, albeit limited, given the bank's strength. And the dividends are subject to ordinary income taxes. ETNs are good for investors who want MLP exposure in tax-deferred accounts like IRAs and 401(k)s. Direct MLP investing in these accounts can subject holders to certain taxes.


Big Gap, Big Opportunity
MLPs yield an average of 6.6%, five percentage points more than 10-year Treasuries. Historically, they've done well when the gap is that wide.

Enterprise Products Partners, at $48, is the largest MLP, and has good growth potential thanks to $7 billion of capital projects. Its yield is a below-average 5.1%, balanced by its growth outlook, a higher-than-average distribution-coverage ratio and distribution increases in 31 straight quarters. Edwards has an Outperform rating and a $59 price target. One plus is that Enterprise doesn't share profits with a general partner, unlike many MLPs, because it bought out its GP in 2010.

KINDER MORGAN ENERGY Partners (ticker: KMP) is big, diversified, and well-managed, with the country's largest natural-gas transportation system. But it allocates 45% of its cash flow to Kinder Morgan (KMI), its GP—one of the industry's highest GP takes.

Kinder Morgan Energy Partners trades at $78 and yields 6.3%, based on an anticipated 2012 distribution of $4.98 per unit. Its sister company, Kinder Morgan Management (KMR), is economically equivalent, but is structured as a corporation and pays the same dividend amount in stock, not cash. KMR, at $72, yields 6.9% and has traded at a persistent discount to KMP. Credit Suisse's Edwards has a $92 price target.

Plains All American, a leading oil transporter, has significant exposure to rising crude production in mid-America. "It's in the sweet spot for the infrastructure build-out theme," says Kyri Loupis, portfolio manager for MLP strategies at Goldman Sachs' investment-management division. Plains, now at 78, has a 5.3% yield. Loupis sees its distributions rising 8% annually over the next three years. He also likes MarkWest Energy Partners (MWE), which trades at 46 with a 6.3% dividend yield, because of its exposure to fast-growing energy production in the Marcellus shale in the Northeast.


Some MLPs, and an exchange-traded fund and note that invest in the sector:

Company/Ticker Recent Price 52-Wk Change 2012E Cash Flow* Price/ Cash Flow Div Yid Stk-Mkt Val (bil)
Boardwalk Pipeline Partners /BWP $25.95 -10.8% $2.11 12.3 8.2% $5.4
Energy Trans Part /ETP 43.39 -8.7 3.78 11.5 8.2 10.2
Enterprise Prods/EPD 48.76 17.1 3.63 13.4 5.1 43.3
Kinder Morgan Eng /KMP 78.33 5.1 5.19 15.1 6.1 26.2
Kinder Morgan Mgt /KMR 71.03 8.8 5.19 13.7 7.0 7.1
Plains All American /PAA 78.53 26.2 6.33 12.4 5.3 12.7
Regency Energy Part /RGP 21.52 -14.6 2.06 10.4 8.6 3.7
ETF or ETN/Ticker
Alerian MLP ETF /AMLP $15.73 -1.3% N/A N/A 6.2% $3.2
JPMorgan Alerian ETN /AMJ 36.54 -0.5 N/A N/A 5.7 4.1
*Per Share E=Estimate N/A=Not Applicable
Sources:Thomson Reuters; Bloomberg; Credit Suisse; JPMorgan
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.DIMITRA DEFOTIS contributed reporting for this article.